Do Dollar-Denominated Emerging Market Corporate Bonds Insure Foreign Exchange Risk?

Abstract

Dollar-denominated emerging market debt is marketed to investors as a way of exposing investors emerging market fixed income securities without exposure to exchange rate risk. However, the development literature suggests that dollarization of debt leads to increased probability of financial distress, which would indirectly expose these securities to exchange rate risk. We empirically examine the exposure of dollar-denominated corporate bonds to exchange rate risk in 14 emerging markets. We find that nearly three-fourths of bonds have yield spreads with statistically significant exposure to innovations in exchange rates, exchange rate volatility, or both. In a reduced-form bond pricing model with default risk, we find economically significant exposures of credit spreads to exchange rates and exchange rate volatility.